A transfer price is the price one subunit charges for a product or service supplied to another subunit of the same

organization.

Intermediate products are the products transferred between subunits of an organization. AB Company Ltd C Company Ltd

Firm with vertical integration, having different value-creating activities in the value chain
Division A TP = Variable cost + Lost contribution per unit per unit on outside sales

Division B

A buys from B at mutually agreed transfer Price

A buys from company C at prevailing market price

Market-based Transfer Prices

Cost-based Transfer Prices

Negotiated Transfer Prices

A common approach is to set the transfer price equal to the price in the external market Market price is best transfer price as it represents the opportunity cost from point of view of both the division are concerned. Market prices also serve to evaluate the economic viability and profitability of divisions individually.

Essentials
profit is the performance measure

Constraints
For differentiated products- no outside source exists.

freedom to outsource

Capacity shortage / excess

Market price is easily available

What is right market price ? Ex -factory / Wholesalers / Customers

When transfer prices are based on full cost plus a markup, suboptimal decisions can result. Cost based transfer price are used when there is no outside buyer available It involves two tasks: ---- Determine the cost of products -----To set up the profit mark up About half of the major companies in the world transfer items at cost.

Variable cost

Full cost

Dual Pricing
Dual Transfer Prices selling product at different prices in different markets the practice of setting different prices for the same product in the different markets in which it is sold The practice of setting prices at different levels depending on the currency used to make the purchase. Dual pricing may be used to accomplish a variety of goals, such as to gain entry into a foreign market by offering unusually low prices to buyers using the foreign currency, or as a method of price discrimination .

Minimum Transfer Price = Incremental Cost + Opportunity Cost.

Variable cost: under this approach variable cost is set as the transfer price.
The problem with this approach is that the producing division is not allowed to show and contribution on the transferred goods, even if it has excess capacity

Under this method transfer price is equal to variable cost of Variable costs the product plus an allocated portion of the fixed overheads. Transfer price based on full cost run the risk of causing dysfunctional decision making behavior. This happens because the buying division perceives the fixed cost to the company as a whole as variable cost to the buying division

Negotiated transfer prices arise from the outcome of a bargaining process between selling and buying divisions Division managers actually negotiate the price at which the transfer will be made. Sometimes they start with market price and make adjustments for various reasons. This method is used sometimes when no external market exists for the product.

Two drawbacks of this method are -divisiveness and competition between division managers and undue weight age to negotiating skills of a manager in appraising his performance

Virtually any type of transfer pricing policy can lead to dysfunctional behavior actions taken in conflict with organizational goals.

1Goal Congruence

2 Subunit Performance Evaluation

3 Autonomy to division without subverting the firms goals

4 Motivation to all concerned division

5 Ensure the cost control at every division

6 Multinational companies use transfer pricing to minimize their worldwide taxes, duties, and tariffs

Factor Influencing Transfer pricing

Nature of Industry

Culture Prevailed

Organization Structure

Role of Corporate Office

Extend of negotiation

Capacity utilization

Type of manufacturing process

Buyers or sellers market

Comparison of Methods
Achieves Goal Congruence

Market Price:

Yes, if markets competitive

Cost-Based:
Negotiated:

Often, but not always

Yes

Comparison of Methods
Useful for Evaluating Subunit Performance

Market Price:

Yes, if markets competitive

Cost-Based: Negotiated:

Difficult, unless transfer price exceeds full cost

Yes

Comparison of Methods
Motivates Management Effort

Market Price:

Yes

Cost-Based:

Yes, if based on budgeted costs; less incentive if based on actual cost

Negotiated:

Yes

Comparison of Methods
Preserves Subunit Autonomy

Market Price:

Yes, if markets competitive

Cost-Based:
Negotiated:

No, it is rule based

Yes

Comparison of Methods
Other Factors

Market Price:

No market may exist

Cost-Based:

Useful for determining full-cost; easy to implement

Negotiated:

Bargaining takes time and may need to be reviewed

Transfer Pricing Approaches

1. Cost-based approach

Variable cost Full (absorption cost)

2. Market price 3. Negotiated market price

Transfer price = Variable cost per unit + Lost contribution per unit on outside sales

This relationship identifies the minimum and maximum transfer prices

A Transfer Pricing Problem

Assume the following data for division A: Capacity in units 50,000 Selling price to outside $15 Variable cost per unit 8 Fixed costs per unit (based on capacity) 5 Division B would like to purchase units for division A. Division B is currently purchasing 5,000 units per year from an outside source at a cost of $14.

A Transfer Problem Example (Continued)

1. Assume division A has idle capacity in excess of 10,000 units: Minimum transfer price = Variable cost + Lost contribution margin = $8 + $0 = $8 2. Assume division A is working at capacity: Transfer Price = Variable cost + Lost contribution margin = $8 + $7 = $15 (market price) 3. Assume division A is working at capacity, but a negotiated $2 in variable costs can be avoided on intercompany sales: Transfer Price = Variable cost + Lost contribution margin = $6 + $7 = $13 (negotiated price)

Strategic Factors
International Transfer Pricing Consideration
Tax Rate- minimize taxes locally as well internationally Exchange Rate Custom Charges Risk of expropriation Currency Restriction

Strategic relationship
Assist bayside division to grow Gain entrance in the new country Suppliers quality or name

Comparison of Transfer-Pricing Methods

Criteria
Achieves Goal Congruence

MarketBased
Yes, when markets are competitive

CostBased
Often, but not always

Negotiated
Yes

Useful for Evaluating Subunit Performance

Yes, when markets are competitive

Difficult unless transfer price exceeds full cost and even then is somewhat arbitrary

Yes, but transfer prices are affected by bargaining strengths of the buying and selling divisions

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Comparison of Transfer-Pricing Methods

Criteria
Motivates Management Effort

MarketBased
Yes

CostBased
Yes, when based on budgeted costs; less incentive to control costs if transfers are based on actual costs

Negotiated
Yes

Preserves Subunit Autonomy

Yes, when markets are competitive

No, because it is rule-based

Yes, because it is based on negotiations between subunits

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Comparison of Transfer-Pricing Methods

Criteria
Other Factors

MarketBased

CostBased

Negotiated

No market may Useful for Bargaining and exist or determining negotiations markets may full cost of take time and be imperfect or products; easy may need to be in distress to implement reviewed repeatedly as conditions change

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Transfer Pricing Implementation

Disputes over transfer pricing occur frequently because transfer prices influence performance evaluation of managers Internal accounting data are often used to set transfer prices, even when external market prices are available Classifying costs as fixed or variable can influence transfer prices determined by internal accounting data To reduce transfer pricing disputes, firms may reorganize by combining interdependent segments or spinning off some segments as separate firms

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